Levelling the field

Central and Eastern Europe has endured over a decade of sustained change since the collapse of communism but the accession countries are moving closer to EU integration and Europe’s youngest private equity industry is growing up fast. Further developments are needed before it can shake off its emerging market tag but the region, led by Poland, Hungary and the Czech Republic, shares an increasing number of features with the markets of Western Europe. Louise Cowley looks at how Central and Eastern Europe is progressing and the factors holding it back.

While no one expects buyouts in Central and Eastern Europe to mushroom overnight, the region is witnessing the beginnings of a market. The flow of deals may still be more of a trickle and transaction values remain low, but factors such as increasing availability of debt bode well. Joanna James, managing director with responsibility for Central Europe at Advent International says the firm has two buyouts in the pipeline, and Polish fund Innova Capital expects to complete between two and four buyouts from its current fund.

Despite the cultural, legal and economic differences compared to Western Europe there’s no reason for buyouts not to develop in the region. It will take time for those involved to become familiar with the complex structures used so casually elsewhere and deal sizes are expected to rise slowly. “At the moment a $20 million deal is pretty big and there might be one $100 million deal in the whole region each year,” says James.

Advent’s largest deal to date was a $65 million investment in Poland’s @Entertainment in 1996, listed on NASDAQ in 1997 and sold to UPC in 1999. At the top end of the scale, the proposed EURO2 billion sale of the Czech government’s stake in Cesky Telecom, which was cancelled in April, was the first time major buyout funds had looked at investing in the region. James believes the experience may leave them disenchanted. The deal was far from typical, and for this reason other local investors doubt there will be implications. The general feeling is that while its failure was frustrating for the bidders, it was not surprising as there is still limited understanding of the buyout process among vendors. Janusz Heath, managing director of Central and Eastern Europe for Dresdner Kleinwort Capital, says the firm has chosen to avoid privatisations, as working with governments can be difficult and such deals are time consuming and resource intensive.

Since last October Dresdner Kleinwort Capital (and headhunting firm Pedersen & Partners) have launched buyout clubs in Poland, Hungary and the Czech Republic. The aim of the meetings, attended by senior managers and CEOs, is to identify opportunities in the region. Issues relating to MBOs and MBIs, such as legal questions, taxation, corporate re-engineering theories and valuation and pricing issues will be among the topics discussed. Heath says: “Obviously we are optimistic about buyout development but there isn’t a market at the moment, there’s no momentum.” He reports an incredibly positive response to the November launch of the club in Poland and although the club was only established in the Czech Republic last month Heath says the response was comparable.

Although the buyout concept is just getting off the ground Heath expects the Western European and US cycle of 10 to 20 years ago to replay. The biggest constraints are the countries’ commercial codes and a lack of debt, although progress is being made on both fronts. The next phase for the region will be the emergence of large dedicated buyout funds.

According to James: “Until now the buyout market hasn’t expanded because there’s not been any leverage available.” However, privatisation of the region’s banks means most are now under international ownership, largely held by continental banks, and are beginning to look seriously at providing structured finance. James points out that Britain has lost out in this expanding market, as none of the biggest UK players are present in the region. One of the issues that does need to be tackled is the banking security laws, which do not recognise floating charges over the assets of a company, and the lack of a central register of securities. Steven Buckley, managing partner of Innova Capital, says one of the technical considerations when attempting a buyout is that the target company cannot be used to guarantee the debt of the acquisition vehicle, or newco. This makes deals clumsy and difficult.

Gyuri Karady, managing partner of Baring Private Equity Partner’s Central European fund, says deal sizes do not yet warrant the use of debt. It is still expensive in this part of Europe, and it is also desirable to minimise risk where possible. He believes good returns can still be produced without the need for leverage. Many industrial managers are nervous about the prospect of heavy borrowing. Comparative freedom of debt in the past, when banks’ lending processes lacked the discipline international ownership has introduced, meant companies previously owned by the state had a heavy debt burden; not something they are keen to repeat unless necessary. However, as deal sizes increase and banks become more sophisticated they will be forced to turn to more risky Western European structures.

The growing interest in buyouts has been helped by developments in mezzanine. Mezzanine Management is currently raising the region’s first dedicated mezzanine fund, Accession Mezzanine Capital. Buckley said: “The Mezzanine Management fund is important, not necessarily in terms of volume but it will help build capabilities. We’ll be able to do deals we couldn’t do otherwise and more Western European-style transactions.” Banks in the region will certainly be looking closely at the first few deals to come out of this fund, which could be an important catalyst in getting local banks into the market. The fund held a first close at EURO75 million in May and is already looking at a handful of deals.

Despite the opportunities for public-to-private transactions Buckley believes the growth in buyouts will be limited by the problems completing such deals. At the end of the nineties there was a lot interest in the region’s stock markets from US and UK emerging market funds. This demand has disappeared and there are no local institutional investors, such as pension funds, to replace them. Many companies listed too early during the previous boom, and there are now more companies trying to delist than list.

However, in Poland, potentially the biggest market, PTPs are cumbersome and highly regulated to discourage delisting while the country tries to build its public market. Strict regulations govern prices and the way that offers, which in an attempt to protect minority holdings have to be made to all shareholders, are made. Despite this, PTPs are possible. DrKC is currently in the process of taking Polish confectioner, Mieszko, off the market. The firm is purchasing part of the stake held by the controlling Gajdzinski family and although this part of the deal has been agreed, Polish law requires that a formal offer for these shares still has to be made.

Following a similar pattern throughout Europe, early stage investing has declined in Central and Eastern Europe. While there are funds like Advent, Baring and DrKC investing international money in deals of $20 million to $30 million, at the other end of the spectrum there are few local players raising money, leaving a gap at the lower end of the market. This means companies initially financed by incubators, of which there were once plenty, have not been able to secure follow-on funding for second or third rounds. At $2 million Baring’s last investment, in Falcon-Vision, a company that produces industrial vision and image processing systems, might look like a start-up. However the company was founded in 1996 and has secured clients such as GE Lighting and Audi. Buckley says: “Two types of deals are predominant – expansion capital increasingly acquisition-orientated and buyouts, an area that’s going to be growing.” He believes the risks of investing in the region are decreasing. Since raising its first fund in 1994 Innova has evolved from investing in start-ups to EBITDA-positive companies.

The criteria for choosing deals may err on the cautious side but familiar principles apply. Karady says he looks for companies with established client bases and proven management teams with a vision for the future, in sectors where growth is expected.

One of the most popular sectors is media, which is benefiting from expansion of the advertising culture. Baring has three investments in printing (Allami Nyomda, Poligrafia and Infopress) and one in a media broker and broadcaster (CR Media). Advent holds stakes in two Polish radio stations (Radio Kolor and Radio Zet) and an advertising group (Euromedia). DrKC’s most recent investment, announced in May, was also to support the expansion of Polish radio station, Radio PLUS. Advent’s sector focus on high growth industries such as media, telecoms, broadcasting, IT and retail, reflects a lack of leverage. Old economy companies are unlikely to grow at the necessary rate and rely on leverage to make a profit. For this reason most funds have pursued a buy and build strategy across the region.

The limited size of the individual markets that make up the region means many investors look for companies with operations in more than one country or that are capable of pan-regional expansion. Steven Buckley, managing partner of Innova Capital, is also looking for cross-border opportunities with Scandinavian, Austrian or German companies that operate in Central and Eastern Europe, as 20 per cent of Innova’s fund can be invested outside the region. The increasing number of this type of integration deals shows the region is moving closer to the rest of Europe.

Fund raising

Like most private equity markets Central and Eastern Europe is challenged by the current fund raising climate and investors are still not fully comfortable investing in the region. There is a perceived lack of good funds and little new money has been raised since mid-2000. Armando D’Amico of placement agent Acanthus Advisers provides advice to institutional investors, including a fund-of-funds manager. His background includes working at the European Bank for Reconstruction and Development and he has conducted surveys of investor sentiment towards the region. “The investor survey last year showed they still have issues with the region. There are macro-economic factors and doubts about accession, the timing, that things are not in place and that it won’t go as planned. There are no public markets and classic issues such as transparency are still there. Investors are still wary of investing in Spain and Italy, although they are coming round. In this scale Eastern Europe is one step behind.”

One of the factors putting investors off Central and Eastern Europe is the lack of exits and extended holding periods. “One of my concerns is that I don’t believe all of the deals can be exited. There are funds with zombie portfolios’ and limited track record,” says D’Amico. Buckley agrees there is no really good source of exits at the moment, with limited trade sales possible to German, French, UK and Scandinavian companies expanding in the region. D’Amico concludes: “It’s possible to defuse misconceptions but you can’t convince people to accept low returns.” The last spate of successful exits, in the mid-to-late nineties was brought to a halt by the Russian crisis of 1998. D’Amico says this marked the end of the first private equity cycle in the region and since then many funds have had to reinvent themselves.

He is keen to point out that the picture is not entirely bleak. High profile investors such as CalPERS (the Californian Public Employees Retirement Fund) are active in the region, having invested in Dresdner Kleinwort Capital’s $225 million Emerging Europe Fund. However, private equity allocations of US institutions have contracted since the fund closed last year, with Central Europe one of the first casualties. While there is not much fund raising activity going on in the region, the signs are that once global investor attitudes thaw it should be well placed. “There have been new investors investigating the region, they’re not investing yet but they are beginning the process of familiarisation,” says D’Amico. In the mean time he thinks there is enough capital available to invest over the next two or three years although he expects some consolidation among the smaller funds will be inevitable.

Problems raising fresh capital are exacerbated by a lack of local investors. Pension funds, a valuable source of capital in most private equity markets, are still absent in Central and Eastern Europe. Poland and Hungary have started introducing funds and although they are not yet very large or mature by Western European standards they do promise to develop into a good source of capital for the industry in time. Polish funds are growing fast in terms of volume and sophistication and there is talk of modifying the rules governing assets local pension funds can invest in. However, the regulatory environment is currently pushing them away from private equity and other riskier asset classes. Other local institutional investors are similarly low-key. Steven Buckley says there are some large corporates investing in Poland but there is very little in the way of banks or insurance funds. The general feeling is that it will be at least three years before local institutional sources become more significant.

Poland-based Innova Capital is one of the few firms braving the fund raising market at the moment to raise its third fund. Buckley says the environment is the toughest it has been for the last ten years, especially trying to raise US money. Innova has experienced a 180 degree swing in the origin of its funds. The first fund in 1994 came exclusively from US sources, the 1998 fund was raised 50:50 from US and Europe, while investors in the current fund are all European. “European institutions are more interested in the region and willing to buy the proposition that EU convergence and accession will boost the market,” says Buckley. The fund currently stands at just over EURO110 million and is due to hold its final close in September.

Regulatory conditions

One of the factors discouraging investors is problems with the local legal system. “You only invest where you can rely on contracts corruption is an issue,” says Joanna James. She cites the use of arbitration contracts to minimise involvement with local legal systems. The tradition of jurisprudence may be missing but as the main investment targets work towards EU accession they are bringing their laws in line with the rest of Europe. Janusz Heath says the Czech insolvency laws are weak and difficult to enforce: “It’s not the laws that are the problem but the system, it is inefficient and over-stretched.” Karady says there are no more legal quirks in Central and Eastern Europe than in other countries and they should be viewed as differences rather than problems.

Joining the EU is clearly going to help the regulatory and legal environment as Central and Eastern European nations will have to conform. Heath says the key for commercial codes in the region is flexibility, and a judicial system that is consistent and efficient. “We want governments to provide an open and flexible legal system and then leave us alone to get on with it. We don’t need subsidies or tax-breaks,” says James. Buckley suggests this is a problem: “There’s no proactive support for venture capital from the governments, no subsidisation along the lines of VCTs in the UK.” Hungary and Poland are perceived as having the most friendly legal environment for buyouts, with Hungary even passing a law on venture capital investments, companies and funds in 1998, although there was very little take-up.

Cultural issues

Private equity in Central and Eastern Europe also has ground to cover in a cultural context. In the worst case financial investors and investment funds are still mistrusted due to the voucher funds of the early nineties. Only in the last 12 years has there been a concept of ownership and with marketing and sales as new concepts it is sometimes difficult to adapt to the competitive open market. Positively, there are an increasing number of Western trained managers and James says Advent tends to back younger managers in Central Europe than they do elsewhere. The younger generation looks to the US model of building a company and then selling it on, while the older generation is often reluctant to relinquish control. There is still some resistance to ownership transition and outside finance, although Karady notes this is not region-specific but the same knee-jerk reaction that comes into play elsewhere. Comparing reactions to Dresdner Kleinwort Capital’s new buyout clubs, Heath said that although there is no shortage of good industrial managers in Hungary, they were more cynical about their ability and lacked confidence compared to their counterparts in Poland and the Czech Republic.

Despite the trend for pan-regional funds there is a distinct investment environment in each nation. “What’s really important is that the region is not homogenous, but then neither is the US, Asia or the rest of Europe. There are cultural differences between the countries,” says Karady. This principle is clearly taken to heart as funds headquartered in London now tend to cover the region through a network of offices. Advent is present in Warsaw, Budapest and Bucharest (with affiliates in Prague, Bratislava and Zagreb), Dresdner Kleinwort Capital has offices in Warsaw, Budapest and Prague and Baring Private Equity Partners is based in Warsaw and Bucharest. Now the market is more sophisticated, PE funds are more rounded organisations benefiting from a mix of nationalities, whereas in the past they were heavily weighted with professionals from the US. Local and Western teams have melded and the industry benefits from the best of both worlds.

Despite all the obvious differences between Central and Eastern Europe and Western Europe, and between the individual nations, investors are keen to focus on the similarities. “People say Central Europe is riskier. This is still very much the perception, and parts of it such as Russia and Serbia may be so, but you don’t invest there in the same way. The investment considerations and investment process in Poland and Hungary are very similar to Western Europe,” says Karady. The real measure of success for the region’s private equity industry will be the end of segregation and to be included in the investment remit of European funds. Karady adds: “Central Europe is Europe. Investors shouldn’t fret about how it’s different, they should look for the similarities and if comfortable with what they find, just get on with it.”

If reports that the region is weathering the slowdown better than the US and Western European economies are sustained, the industry may have the chance to emerge on a more level pegging. In the past returns have been dependent on the use of leverage or the high growth rates of portfolio companies. But Buckley believes the increased importance of operational skills in seeing investment companies through difficult times may benefit firms in Central and Eastern Europe. “The limited size of the management team means we have to get our hands dirty. This gives us an advantage over US and European funds in the current climate, as they tend to be more removed,” he says. “Times are tough, growth rates are down especially in Poland. Portfolio companies may be having a hard time but it’s the best investment environment for this region in 12 years,” concludes Buckley.